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Reviewing Utility Fair Market Value Appraisals

Reviewing utility fair market value appraisals by Ashley Everette, PA. Appraisals determine the rate base for rate-making. Compliance with the Uniform Standards of Professional Appraisal Practice (USPAP) is required.

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Reviewing Utility Fair Market Value Appraisals

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  1. Reviewing Utility Fair Market Value Appraisals by Ashley Everette, Pa. Office of Consumer Advocate

  2. The average of the appraisals determines the “fair market value” • The lower of the purchase price and the fair market value becomes the ratemaking rate base Role of the Appraisal Two utility valuation experts shall perform two separate appraisals of the selling utility for the purpose of establishing its fair market value. 66 Pa. C.S. § 1329(a)(2) Add a footer

  3. The ratemaking rate base affects rates in a direct and measurable way • Appraisals are not formulaic; they are subject to judgement Why do we need to look at the appraisals? Add a footer

  4. The appraisals are to be performed in compliance with the Uniform Standards of Professional Appraisal Practice, or USPAP • USPAP is standards for appraisals including competitive business valuations and real estate; is not specific to valuing cost-regulated utility business Appraisal Standards Each utility valuation expert shall determine fair market value in compliance with the Uniform Standards of Professional Appraisal Practice, employing the cost, market and income approaches. 66 Pa. C.S. § 1329(a)(3) Add a footer

  5. USPAP Exceptions JURISDICTIONAL EXCEPTION: an assignment condition established by applicable law or regulation, which precludes an appraiser from complying with a part of USPAP. 2018-2019 USPAP Manual, page 5 Add a footer

  6. Asset Purchase Agreement • Customer Notices • Licensed Engineer’ Report of Assets • Appraisal • Cost Approach • Market Approach • Income Approach Components of a Fair Market Value Application Add a footer

  7. Purchase price, including any provisions tying the purchase price to the appraisal results • Rate commitments such as rate freezes or limitations on future rate increases (e.g. Compound Annual Growth Rate, or CAGR restrictions) • Guarantees of capital improvements or other investments What to look for in the Asset Purchase Agreement Add a footer

  8. The ratemaking rate base determination will directly impact rates in the next base rate case • Most of the fair market value acquisitions we have seen are likely to increase existing and acquired customers’ rates • Customers should receive notice of the proposed acquisition and how it may affect their rates Customer Notice Add a footer

  9. Cost Approach A procedure to estimate the current costs to reproduce or create a property with another of comparable use and marketability. "Approaches to Value." American Society of Appraisers, www.appraisers.org Add a footer

  10. The acquiring public utility or entity and selling utility shall engage the services of the same licensed engineer to conduct an assessment of the tangible assets of the selling utility. The assessment shall be incorporated into the appraisal under the cost approach required under paragraph (3). 66 Pa. C.S. § 1329(a)(4) Cost Approach: Engineer’s Assessment Add a footer

  11. How are asset values determined? • Are all assets used and useful? • Does the selling utility have ownership of all assets it is selling? Engineer’s Assessment:Preliminary Review Add a footer

  12. OCN: Original Cost New • OCNLD: Original Cost New Less Depreciation • RCN: Reproduction/Replacement Cost New • RCNLD: Reproduction/Replacement Cost New Less Depreciation Cost Approach:Commonly Used Terms Add a footer

  13. RCN is generally calculated by indexing OCN plant values to translate original costs into present-day costs. • Handy-Whitman Index (utility specific) • ENR Index (construction index) • Other indexes (BLS, AUS) for land, communications equipment, etc. Cost Approach:Reproduction Cost Add a footer

  14. Reproduction cost of some assets calculated by indexing, other assets using an estimate of present-day costs (this increased the Cost Approach result by more than 30%) • Future capital improvements included in the Cost Approach • Cost Approach increased for “going value” i.e. goodwill • Inclusion of developer-funded plant that had not been dedicated to the municipality • Double-trending of costs inflates the RCN (see appendix for example) Cost Approach:Issues we have seen Add a footer

  15. Market Approach A procedure to conclude an opinion of value for a property by comparing it with similar properties that have been sold or are for sale in the relevant marketplace by making adjustments to prices based on marketplace conditions and the properties’ characteristics of value. "Approaches to Value." American Society of Appraisers, www.appraisers.org Add a footer

  16. Value of the Seller’s system is determined on a relative basis, calculating ratios of the purchase price/value of other systems using criteria such as these: • Number of customers • Population of Service Territory • OCN • OCNLD • RCNLD • Resulting ratio is multiplied by the relative statistic for the Seller Market Approach Add a footer

  17. Purchase prices for comparable sales used that are in excess of fair market value • Market Approach increased for “going value” i.e. goodwill • Value calculated based on a future number of customers (projected growth) • Purchase price of comparable systems was increased to account for capital improvements the buyer planned to do Market Approach:Issues we have seen (Part 1) Add a footer

  18. Results using a publicly-traded proxy group increased due to customer contributions • Speculative growth and risk adjustments applied to market approach result • Use of book financial indicators to determine the value of comparable systems • Limited proxy groups (e.g. only other FMV acquisitions in PA) • Excluding FMV acquisitions based on their results Market Approach:Issues we have seen (Part 2) Add a footer

  19. Income Approach A procedure to conclude an opinion of present value by calculating the anticipated monetary benefits (such as a stream of income) for an income-producing property. "Approaches to Value." American Society of Appraisers, www.appraisers.org Add a footer

  20. Discount rate • Annual Revenues • Original Cost vs. Reproduction New Cost as basis for depreciation • Annual Tax vs. Book Depreciation • Structure and number annual periods in a model • Estimation of Terminal Values Income Approach Add a footer

  21. Appraisal Weightings Add a footer

  22. Ashley Everette Pennsylvania Office of Consumer Advocate aeverette@paoca.org 717-783-5048 Contact Information Add a footer

  23. Appendix

  24. Reviewing Fair Market Value Appraisals Practical Applications

  25. Cost TrendingExample: 4” ductile iron pipe, installed in 1976 Add a footer

  26. Comparable Acquisition: $160 Million Purchase Price 20,000 Customers; RCNLD of $140 Million $8,000/customer ($160 Million / 20,000 customers) Purchase Price/RCNLD of 1.14 ($160 M / $140 M) Market Approach:Simplified Example Seller’s System: 1,000 Customers; RCNLD of $6 Million Valuation of $8 Million based on number of customers ($8,000 per customer x 1,000 customers) Valuation of $6.84 based on RCNLD (Ratio of 1.14 x RCNLD of $6 Million) Add a footer

  27. Comparable Acquisition: Ratio from Comparable Acquisition Applied to Subject Transaction: Market Approach :Sales Comparison Example Ratio 2.0 Purchase Price $150 M OCNLD $75 M = x Valuation Result $80 M Ratio 2.0 OCNLD $40 M x = Add a footer

  28. Consider whether the claimed OCNLD amount is equivalent to the OCNLD for the acquired system. Comparable Acquisition: Ratio from Comparable Acquisition Applied to Subject Transaction: Market Approach :Sales Comparison Example(continued) Ratio 2.0 Purchase Price $150 M OCNLD $75 M = x Valuation Result $80 M Ratio 2.0 OCNLD $40 M x = Add a footer

  29. Consider whether the claimed OCNLD amount is equivalent to the OCNLD for the acquired system. Comparable Acquisition: Ratio from Comparable Acquisition Applied to Subject Transaction: Market Approach :Sales Comparison Example(continued) Ratio 2.0 Purchase Price $150 M OCNLD $75 M = x 1.5 $60 M 1.5 $100 M Valuation Result $80 M Ratio 2.0 OCNLD $40 M x = Add a footer

  30. When multiple comparable acquisitions are used, how is the result determined? Market Approach :Sales Comparison Example Add a footer

  31. Method of Averaging Matters! • Simple average of ratios: 1.38 • Weighted average: 1.63 • Weighting the average increased the valuation by 17% Market Approach :Sales Comparison Example(continued) Ratio of 1.38 x Seller’s RCNLD $70 M Indicated Value: $97 M Ratio of 1.63 x Seller’s RCNLD $70 M Indicated Value: $114 M Add a footer

  32. Assistance with the Income Approach analysis provided by Glenn Watkins, Technical Associates, Inc. Valuation Issues in the Income Approach Add a footer

  33. Discount Rate Issues • High equity ratios • Returns on equity much lower than those utilized by Commission or those that could be considered reasonable • Understated costs of debt Income Approach:Discount Rate Add a footer

  34. Revenues Revenue assumptions should recognize that the annual revenues will be a function of cost of service under as a regulated public utility Income Approach:Estimated revenues Add a footer

  35. Basis for Depreciation The income approach is calculated on based on depreciated cost. What is the “rate base”? Income Approach:Basis for depreciation Add a footer

  36. Annual Depreciation: Book vs. Tax • When calculating cash flows, tax depreciation is more appropriate to use • If tax depreciation is used, consider the following: • The reversal of tax over book depreciation in future years should be reflected • The use of tax depreciation should be reflected in the expected revenue stream. Income Approach:Determination of annual depreciation Add a footer

  37. Structure and number of annual periods in a model Water and Wastewater utilities’ plant investments have relatively long service lives (35 to up to 75 years). • Most DCF models used for valuations are much abbreviated with only 13 to 20 years of annual cash flows modeled. • In part to reflect the remaining life of plant investments beyond the number of years modeled, “terminal values” are commonly employed. Income Approach: Terminal Values Add a footer

  38. Terminal Values: to reflect the remaining life of plant beyond the years modeled in the DCF • The most common (and inappropriate) method used to estimate terminal values is to apply the last model year’s cash flow to “capitalization” rate. • Under the capitalization approach, net cash flows are assumed to grow at a constant annual growth rate in perpetuity without significant reinvestment of existing plant • This would require the assumption that the annual cash depreciation levels are greater than the level of annual capital expenditures Income Approach: Terminal Values Add a footer

  39. (1) Revenue $1,000,000 (2) Cash O&M Expenses $600,000 (3) Depreciation $300,000 (4) Earnings Before Interest & Taxes $100,000 (5) Income Taxes $35,000 (6) Net Operating Income $65,000 (7) Capital Expenditures $100,000 (8) Change in Working Capital $10,000 (9) Net Cash Flow: (6) + (3) - (7) - (8) $255,000 Notice depreciation (3) on existing plant in last year is significantly greater than capital expenditures (7) to replace plant. It would be mathematically impossible to sustain a positive level of growth in perpetuity when depletion of plant investment is greater than the replenishment of such plant. Terminal Value Example Add a footer

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